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One of the fundamental considerations in lender of last resort (LOLR), whether conventional or Shariah, is that an institution would need the funds fairly quickly, possibly within a day of its request.

How will Islamic financial institutions (IFIs) navigate this demand if and when the need arises?

This is one of the questions discussed in the Exposure Draft of Guidance Note-7 on Shariah-compliant Lender of Last Resort (SLOLR) Facilities issued by the Kuala Lumpur-based Islamic Financial Services Board (IFSB).

Known in short as ED GN-7, the 34-page document is up for public consultation until July 5, primarily targeting central banks, regulatory and supervisory authorities (RSA), international organisations, IFIs and academics.

It is also intended to offer international benchmark guidelines to RSAs for developing and offering SLOLR facilities as part of the financial safety net arrangement for IFIs in their jurisdictions, according to an IFSB statement.

The ED GN-7 is primarily intended to serve as a benchmark for central banks in establishing and operationalising an SLOLR framework that applies to full-fledged Islamic commercial banks and Islamic commercial banks that are subsidiaries of conventional banks.

It covers several essential features of an SLOLR arrangement, including the preconditions for developing and implementing an SLOLR mechanism and eligibility criteria to access SLOLR.

It also covers a non-exhaustive selection of Shariah-compliant structures and mechanisms that central banks could utilise for SLOLR purposes; the applicability of penalty rates to these mechanisms; Shariah-compliant eligible collateral; and the relevant disclosures to be made by central banks to IFIs in their jurisdictions.

The technical committee for the exposure draft is chaired by Khalid Omar Al-Kharji from the Central Bank of the United Arab Emirates. The two Malaysian representatives in the committee are Madelena Mohamed from Bank Negara Malaysia and Datuk Zainal Izlan Zainal Abidin (picture) from the Securities Commission Malaysia (SC).

LOLR capability has emerged as a key aspect of the crisis prevention supervisory framework, and its concept and operational mechanisms have been widely addressed in the conventional literature, the document noted.

However, it added that conventional LOLR facilities normally depend on interest-bearing loans or instruments, and therefore cannot appropriately be extended to institutions offering Islamic financial services.

“Against this background, it is necessary to consider how SLOLR mechanisms might be conceived and used,” it said.

It also noted that a report on Islamic finance and global financial stability issued jointly by the IFSB, the Islamic Development Bank, and the Islamic Research and Training Institute in April 2010 listed the strengthening of financial safety net mechanism as an important building block in strengthening the foundations of the Islamic financial system. In this case, financial safety net mechanism includes LOLR and deposit insurance.

Handling Collateral

When discussing the need for immediate and efficient transfer of SLOLR funds, the document noted that collateral must be quickly transferable to the central bank after an SLOLR request.

It noted that some assets fulfilling the central bank’s collateral eligibility criteria require lengthy processes before they could be transferred.

In that case, it noted that central banks may need to put in place specific measures, customised for each type of acceptable collateral, to facilitate the quick transfer/pledging of assets in SLOLR arrangements.

It cited an example of where IFIs may pre-position collateral with the central bank, which allows the latter time to amend standard legal documentation and ensure smooth transferability in future SLOLR occasions.

Preconditions for Effective SLOLR

The draft note listed out nine pointers when summarising preconditions for effective provision of SLOLR, starting with a sound framework for banking supervision, including a liquidity regime, stress testing, and an effective recovery and resolution regime. The other pointers are:

• For systemic support, there should be an efficient money market, within which liquidity can be allocated by market mechanisms to the banks that are most in need of it;

• The regime should be defined in advance of need, approved by Shariah scholars and published appropriately;

• The requirements for eligibility, collateral, conditions, etc, should also be defined in advance and published;

• The instruments chosen should be capable of being used over a variety of tenors, but primarily short term (particularly overnight);

• At least one of the instruments should be capable of operating as a standing facility, available on demand to any eligible bank able to post the appropriate collateral;

• It should be possible for each instrument to set a penalty rate higher than current market rates;

• Assets used as collateral should be Shariah-compliant; and

• In a dual system, the terms of the SLOLR should be sufficiently close to those of the conventional LOLR to limit arbitrage. This will be particularly important if some banks can use either facility (eg in groups with both conventional and Islamic operations).

IFSB, an international standard-setting organisation, promotes and enhances the soundness and stability of the Islamic financial services industry by issuing global prudential standards and guiding principles for the industry, broadly defined to include the banking, capital markets and insurance sectors.